Mainstream Media Explains the Austrian Theory of the Business Cycle

The Austrian Theory of the Business Cycle was developed by Wicksell, Mises, Hayek, and, in its most-complete form, by Garrison. I could go into a lengthy, boring explanation, but there are people paid much more money than me who’s job it is to explain economics, so I’ll let them do it. These people, it should be noted, are usually wrong, but when the truth (and I do think the Austrian theory is true) is painfully obvious, a paradigm shift inevitably works its way into the dominant narrative.

“Rock-bottom interest rates across major economies, which have been a key response to the crisis, have in many cases prompted governments, firms and consumers to go on a fresh borrowing binge…The World Bank warned that developing countries facing up to the prospect of the flood of cheap money being turned off should be ‘hoping for the best, preparing for the worst'”

The Austrian theory is primarily concerned with interest rates: The state can lower or raise the interest rate by engaging in massive open market operations, buying and selling bonds. In the same way, the state often rigs agricultural prices with open market operations. If the state were to buy apples at above their market price, an apple bubble would develop as suppliers are incentivized to produce more. When apple prices correct to their market levels, there would be a glut of apples from oversupply that will drive prices down below what would have been their market level without the boom.

When the state buys assets like bonds and other securities at above their market level, there is an asset bubble that inevitably pops. If a bond matures for $1 in a year at a 25% interest rate, it will sell for 80 cents today (80 cents multiplied by 125% is $1). If the Fed steps in and buys the bond for 90 cents instead of 80 cents, it effectively lowers the interest rate from 25% to 11%. Bond prices go up when interest rates go down, and vice versa: When interest rates are fixed too low, an asset bubble occurs and then pops in a market correction. The state can keep the asset/apple bubble going, but it’s going to be expensive. Too confusing? I’ll let Forbes explain:

“The Chinese government is worried about the recent sell-off, even though stocks remain 60 percent above year-ago values. The government has created a market stabilization fund to provide loans to buy stocks…Trying to prop up the stock market is a mistake for any government…Political leaders have no skill in determining what these prices should be. Instead, they tend to look at the short-run economic impact of price changes.”

“Federal Reserve Chair Janet Yellen, surveying the financial landscape for signs of bubbles after more than six years of near-zero rates, warned that both stocks and bonds are richly valued…’I would highlight that equity-market valuations at this point generally are quite high,’ Yellen said in Washington on Wednesday in response to a question at a forum on finance…Yellen said bond yields ‘could see a sharp jump’ (and thus bond prices will see a decline) when the Fed raises its benchmark interest rate. Most Fed officials predict that will happen this year for the first time since 2006…’There’s incremental concern about the stock market, and I think there’s an underlying fear about the stock-market reaction to when the Fed starts to tighten'”

When the Fed boosts bond prices i.e. lowers interest rates, it also boosts other asset prices. Consider this: The interest rate relates the price of future and present money. If I have $1 today, and the interest rate is 25%, then I can put it in a bank and have $1.25 in a year. The value of $1 one year from now is 80 cents today. If the interest rate is 11%, the value of $1 one year from now is 90 cents today. If I have a business that will return $1 yearly, then that business is worth more to me in an environment of low interest rates, since money in the future is worth more today. If the state fixes interest rates low temporarily, it fixes both bond and stock prices high temporarily.

The Housing Bubble, the Dot Com Bubble, the recent rash of government debt crises, all of this can be explained with Austrian Business Cycle Theory. It is universal, and it is more and more becoming part of the mindset of mainstream economists and central planners. The Australian Central Bank, for instance, is fully conscious of the housing bubble it is fueling in Sydney, but still presses ahead according to the Australian Broadcasting Corporation:

“Booming Sydney housing prices alone would not derail another cut to interest rates, according to the minutes from the Reserve Bank’s most recent board meeting…The RBA cut the cash rate in May to a new historic low of 2 per cent to stimulate a slowing national economy despite concerns it could fuel a property bubble in Sydney.”

“A further interest rate cut by the Bank of Canada could further fuel flames in the country’s two biggest real estate markets which are once again showing signs of overheating, housing watchers say. ‘It’s another log on the fire for the Toronto and Vancouver housing markets,’ says economist Sal Guatieri, vice president of BMO Economic Research, who expects to see a cut next week in an attempt to kickstart lagging growth…’It’s the message it sends to homeowners and potential buyers that rates are going lower rather than higher and will almost certainly stay low for quite some time. That just encourages more people into the market.'”

“Norway cut its main interest rate to a record low of 1 per cent, as fears over the impact of the low oil price trumped growing concerns over a housing bubble…The rate cut is likely to stoke fears of a housing bubble after two decades of almost uninterrupted price growth and already high and rising household debt…Hilde Bjørnland, a professor at the BI business school in Oslo, warned against a rate cut shortly before the decision. ‘I am much more worried that we move from an oil boom into an even bigger housing boom that explodes with negative effects.'”

Even if the intellectual and governmental powers that be think rate cuts are still necessary, at least they are moving forward under the pretense that the rate cuts are worth the cost, and that the cost is an increased risk of a bubble. Of course, the rate cuts never help the economy in the long term: Only the short term. But the important thing is the paradigm shift. Artificially low interest rates cause asset bubbles, it is a cost of low-interest-rate policy, whether or not you think the cost is worth it, and everyone agrees. The leading economists are finding the same conclusion using different methods, another indicator that a conclusion is valid:

“This paper provides more evidence in the contribution to the much-debated cause of the recent housing bubble. In particular, the Fed’s use of loose monetary policy and any contribution of this expansionary policy to the run-up in housing prices during that time. Generalized method of moments (GMM) is used to estimate empirical Taylor-type policy reaction functions to predict policy reactions based on past behaviors of the Federal Reserve to various economic indicators. The findings are consistent with the view that Federal Reserve held interest rates artificially low. Counterfactuals presented add more evidence that Fed policy was too loose during that time period.”

The method used above is the correlative statistical method, to be distinguished from the deductive causal method of Austrian economics. But it is returning the same conclusion, much as both Newton’s and Einstein’s theory return the same conclusion for experiments done on the human scale. The academics are coming around, and I do think Keynes was right on one thing: “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

Andrew has written for Bitcoin Magazine and the Worcester Telegram and Gazette on the subject of economics. He runs the Boston Austrian Economics Group, the New Hampshire Austrian Economics Group, is interim director of the Bastiat Institute, and has spoken at Liberty Forum and Porcfest on the topics of homesteading, Lockean vs. Occupancy-and-Use property rights, and the difference between feudal and market societies.

Great article, thanks. It’s good to see this stuff being talked about. We’ll know we’ve finally arrived when Paul Krugman is unemployed…

Even if there was a central authority smart enough to manage the economy by adjusting interest rates, we’d still have the problem of motivation. It’s nice to think they’re doing this to make our lives better, but they’ll have no inhibitions if it comes to making the state look good in the short term and hurting everybody else in the long term.